Grits, Grats, Gruts What?: Estate Planning-Beyond the Basics

It has been said that the best estate planning is to die shortly before your last check bounces. For those of us not planning on spending every last penny, some attention to estate planning is warranted.

Current law allows each individual a one-time exclusion from estate/gift taxes. The one-time exclusion is currently $650,000 and will increase to $1,000,000 (See Table 1). With proper wills and correct asset ownership, a couple can leave their beneficiaries up to twice the amount of the exclusion without paying any estate/gift taxes. With estate/gift tax rates ranging from 37 percent to 55 percent, proper use of the exclusions available to both spouses is an important first step.

If a couple's wealth, either current or expected, is significant enough so that estate/gift taxes cannot be avoided completely, they should consider gifting property in order to reduce their future estate/gift tax liability and increase the amount of property their beneficiaries will ultimately receive. Once a couple's wealth exceeds the amount necessary or desirable for their own purposes, gifts should be made in a fashion that intelligently utilizes the available exclusions from estate/gift taxes. Gifting assets that have the greatest potential for appreciation is important, as not only the current value of the gifted property is excluded from tax, but also future appreciation. Other techniques involve the use of discounts, that is, gifting property at a discounted value due to a minority ownership interest, illiquidity, or the retention of the use or income of the property for a period of time. Gifts should be leveraged in order to get the biggest bang for your gift tax buck.

Qualified Personal Residence Trust

A Qualified Personal Residence Trust (QPRT) is a modified form of a Grantor Retained Income Trust (GRIT). Prior to the Revenue Reconciliation Act of 1990 (RRA '90), GRITs were very popular estate planning vehicles whereby a person (the grantor) would transfer property to an irrevocable trust and retain the right to receive the income of the trust for a period of years. On the expiration of the trust's term, the remaining property was then distributed to the trust beneficiaries, typically the grantor's children. The initial gift of property to the trust was discounted from the fair market value of the property contributed due to the income interest retained by the grantor. In many cases, the trust property was placed in investments that did not produce income, such as stocks or mutual funds. This had the effect of reducing the income paid to the grantor and increasing the value of the trust property transferred to the remainder beneficiaries. In substance, the grantor received a discount in the value of the gift due to a right to receive income which in reality was never paid.

GRITs were effectively eliminated by RRA '90; however, the transfer of a personal residence into a trust with a retained right to use the residence for a specified term was excepted from the limitations imposed by RRA '90. The QPRT or "house GRIT" as it is sometimes referred to allows the grantor to transfer a personal residence into a trust, retain the right to use the residence for a specified time period and receive a discounted gift valuation. Depending on the length of the retained interest, the reduction in the value of the gift can be substantial. Assuming that the home appreciates in value during the term of the QPRT, the grantor's home will be transferred to the remainder beneficiaries at a significantly discounted amount. While it is possible to fund a QPRT with a residence that is currently mortgaged, it is not recommended due to the additional complexities which must be addressed.

Grantor Retained Annuity Trust and Grantor Retained Unitrust

The RRA '90 limitations on the use of GRITs generally provide that any retained interest in a trust must actually be paid out to the grantor. This has led to the creation of the Grantor Retained Annuity Trust (GRAT) and the Grantor Retained Unitrust (GRUT). With a GRAT, the grantor retains the right to an annual payment from the trust for a term of years. The retained annuity reduces the amount of the grantor's gift. A GRUT is similar except that the retained annuity is expressed as a percentage of the trust property at the beginning of each year during the trust's term.

While GRATs and GRUTs do not achieve the leverage that was available with GRITs prior to RRA '90, they can still be useful in leveraging gifts of assets that will appreciate at a rate greater than the expected rate of return mandated by the Internal Revenue Service (IRS). Currently (February, 1999), the IRS assumes a 5.6 percent average rate of return. If the assets gifted to the GRAT or GRUT outperform the rate set by the IRS, the value of the property ultimately transferred to the remainder beneficiaries will exceed the value of the gift calculated for purposes the grantor's gift tax return.

Family Owned Entities

Family limited partnerships and other closely held entities have recently gained popularity as vehicles for making gifts at discounted values. The basic technique involves making gifts of minority ownership interests in existing or recently created entities. The value of such gifts is discounted due to such restrictions as lack of marketability and/or lack of control. The value of the underlying assets remains the same; however, the limitations on control and marketability inherent in a minority ownership interest reduce the value of the gift for gift tax purposes. An additional benefit of this technique is the ability of the majority owner to retain control over the property and business decisions of the entity. Properly used, gifts of minority ownership interests in family entities can substantially reduce a person's overall estate tax liability. This technique has undergone close scrutiny by the IRS, but remains a valuable and viable technique.

Conclusion

In summary, in order to reduce estate/gift taxes on a large estate it is necessary to consider gifting and there are a variety of methods available to leverage the use of existing estate/gift exclusions in order to allow property to be gifted at a minimal tax cost.